Tuesday, 11 May 2010

Panic on the Markets or Cyber Attack?

This one is a bit technical! Last Thursday 6th May there was a massive 9% drop on the Dow Jones. In just a matter of seconds it fell 500 points. http://business.timesonline.co.uk/tol/business/markets/article7119054.ece 
There is speculation that some unfortunate trader made a very big mistake with a zero or two, giving the market the downward nudge that then unleashed a series of program trades, which then pushed it down a further few hundred points. An investigation by the Securities and Exchange Commission (SEC) is underway. Because there was no underlying reason for the market to suddenly drop it recovered during the next trading session, but the event sent shock waves around the world’s markets.
Back in the mists of time, circa 1968, when I was studying control systems as part of my chemical engineering course at Exeter, I was taught about how to ensure that a control system was stable and didn’t shoot off to one extreme or the other at the slightest perturbation. In spite of having an analogue computer to demonstrate it, rather like the one on the right, I didn’t really understand it at the time, not intuitively anyway! http://en.wikipedia.org/wiki/Analog_computer It was only later, when I was able to see the effect that changes to the control parameters had on real systems, that I began to appreciate what my lecturers had been trying to teach me. In a three term controller you have three settings: Gain, Derivative and Integral time all acting on a system with inertia, in other words a system which takes time to react to the change in the setpoint value. This article explains it very well.
It is clear to me that program trading has increased the sensitivity, “the Gain” in the stock market. On the other hand the system inertia, the period of time it took for traders and investors to hear of an event and to decide what to do, has been shortened to milliseconds. The integral control term, which over time brings the system back to its new state of stability, still exists because not all trading is done using computers, people do act in the market, and eventually, if there is no rational reason for the market to stay down, then there is money to be made by buying and waiting for it to rise.
So if regulators want to avoid the sort of unnecessary panic that was created last Thursday, then they need to either delay program trades or limit their size. The problem is that the smart guys can use their program trades to make money. By being able to react so quickly they can take advantage of smaller investors who are not so well equipped. So whilst the smaller investors are still selling, reacting to the original drop in value, which may have happened a few hours ago, the smart guys have programmed their computers to buy as soon as the price starts to rise and are buying up the bargains in the basement. The smart guys, who are all large financial institutions with lots of political pull, will not want anything changed to limit their money making opportunities so the SEC is unlikely to take any action, which in any case would have to be by international agreement.
There is another aspect to consider. In such an unstable system what if there was a politically motivated “cyber attack” designed to assault the capitalist system at its heart.
I wonder what the security protocols are for connecting to the Stock Markets, how easy is it to crack them and who might be motivated to do so?  What are the authorities doing about it? Anyone who knows is very welcome to reassure me!


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